Update on US Banks and the Euro Area – Things Look Grim

Now on to a somewhat less happy topic, namely the US banks, especially the so-called ‘TBTF’ banks. As long time readers are probably aware, we have always held that people will tend to underestimate the ‘stickiness’ of the down cycle in real estate. However, there are a number of historical examples of which the most pertinent is probably Japan’s experience since the early 1990’s that show that burst mortgage credit and real estate bubbles are quite prone to lead to a persistent secular contraction, especially if the government continually intervenes in the market to prevent it from reaching clearing levels. As it has turned out, the US administration and the Federal Reserve have in concert repeated precisely what Japan’s government did when faced with a collapsing housing bubble. Not ‘precisely’ in the sense that the interventions are similar in all details, but in terms of the scope and intent it certainly appears that the US have cloned Japan’s failed policies. It is quite amusing to think back to how US pundits, politicians and regulators kept admonishing Japan throughout the 1990’s over such policies. Today the world’s new Zombie Bank center is no longer Tokyo, but New York.

Readers may also recall that we have often talked about what we term the ‘moving target problem’. The banks may have been diligent in raising new capital and may have taken the odd write-off here or there, but in the meantime the value of their collateral keeps declining. The moment they try to expedite foreclosures it can be expected that their write-offs will increase sharply, as collateral values lurch even lower and losses currently held in accounting limbo abeyance are recognized (currently it takes nearly 600 days for a foreclosure to be processed. Due to fresh uncertainties faced by lenders over the question of legal title to properties that are the collateral to loans that have been securitized, foreclosure activities have been slowed down even further). Note here that US commercial banks still hold some $2.9 trillion in mortgage related assets.

As we have noted before, there are furthermore doubts as to the true extent to which US banks are exposed to the troubles in the euro area. The banks themselves say their exposure is negligible, but the data published by the BIS say otherwise. According to the BIS, US banks hold some $520 billion in derivatives exposure related to Europe. Naturally these are gross exposures, but one must always keep in mind that ‘netted’ exposure ultimately depends on the solvency of counterparties. As was seen in the AIG case, derivatives hedges are worth nothing if the counterparty to them blows up. If not for the involuntary conscription of tax payers courtesy of the Fed, Goldman Sachs and many others would have recorded billions in losses, far exceeding their ‘netted’ value at risk.

We suspect that US banks are among the biggest writers of CDS on euro-land sovereigns and that they are therefore exposed to far higher risk than they admit to. After all, there is a non-negligible chance that the euro area will indeed ‘blow up’, which could conceivably result in cascading cross-defaults of fractionally reserved banks across the continent.

Lastly, the stated book value of many US banks is highly dubious. One example is Bank of America, which sports $70.8 billion in ‘goodwill’ on its balance sheet, a sum that comfortably exceeds its depressed market capitalization. This goodwill is left over from the string of ill-advised acquisitions BAC’s former CEO Ken Lewis engaged in, ranging from Countrywide (today the biggest albatross around the bank’s neck) to Merrill Lynch. Both of these firms would likely have gone bankrupt if not for Mr. Lewis’ generous takeovers. For instance, he paid $50 billion for Merrill Lynch. Had he waited another two or three months he could have gotten it for $1, and even then he would probably have overpaid.